1/23/2006 @ 6:00AM

Trials And Tribulations Of Enron And S-Ox

In the next few weeks, the trial of Ken Lay and Jeffrey Skilling–founding members of Enrons Hall of Shame–will commence. The trial coincides with the approaching fifth anniversary of Enron’s demise, which, along with other subsequent corporate implosions, led to passage of the Sarbanes-Oxley Act, badly and hastily written legislation with the salutary purpose of enhancing corporate governance and transparency.

While it’s impossible (or at least foolhardy) to predict how a jury of Lay’s and Skilling’s “peers” will assess the legality of their conduct at Enron, it’s definitely possible to assess how S-Ox is working and whether–all things considered–the cure is worse than the disease.

The principal deficiencies that led to Enron’s demise are easy enough to catalog. They include, in no special order:

–A serious lack of meaningful internal controls;

–Directors who didnt really understand their functions or how to perform them;

–Rampant conflicts of interest between senior managers and the shareholders of Enron;

–Off-balance-sheet obscuring of significant liabilities;

–Impenetrable accounting chicanery, designed to make the company look profitable; and

–A culture of lawlessness and unaccountability.

Perhaps first and foremost, S-Ox was intended to preclude the “four-monkey” defense that both Lay and Skilling can be expected to raise (as did Bernard Ebbers and Richard Scrushy before them):

–I didn’t say anything;

–I didn’t do anything;

–I didn’t know anything; and

–I most certainly didn’t understand anything!

Whatever its other flaws, in S-Ox we have a clear delineation of who bears responsibility for the conduct and performance of public companies–senior managers and the directors. So my hope is that, with all that has passed, neither Lay nor Skilling will be able to assert the “four-monkey” defense successfully.

Since S-Ox’s passage, accountants, the U.S. Securities and Exchange Commission, stock exchanges and corporations have focused needed attention on procedures and controls, and that focus has immeasurably improved the quality, transparency and accessibility of corporate information. It’s also had a salutary effect on businesses’ bottom lines.

The 2005 Oversight Systems Financial Executive Report on S-Ox surveyed more than 200 financial executives and found a significant majority believe that, after implementing requirements to remedy control deficiencies, they have seen bottom-line business benefits. Nearly half said S-Ox compliance resulted in reduced risk of fraud and errors, and they now have more efficient operations. In a 2005 Ernst & Young survey, 87% of respondents noted enhanced accountability and ownership of controls as areas of added value provided by S-Ox.

It’s easy to overlook the long-term benefits that companies derive from these changes by focusing exclusively on the immediate short-term costs that S-Ox imposes. Anyone who has been operating at the intersection of GAAP accounting and tax and management reports will appreciate the ability S-Ox offers to reconcile them.

Unfortunately, that doesnt change the fact that the costs of these improvements are thought by many businessmen and businesswomen to outweigh the benefits. S-Ox has certainly and substantially increased corporate-compliance costs. AMR Research estimates that companies will spend $6 billion to comply with S-Ox in 2006, on a par with the amount spent in 2005. Corporate executives have railed against the excessive costs of implementing S-Ox, threatening delisting, abandonment of America for Europe, and the end of America’s capital markets.

Of particular concern is that S-Ox imposes disproportionate burdens on small and foreign companies. Despite SEC importuning, Congress refused to allow the SEC to make distinctions based on a company’s size or nationality. As a result, the SEC has wisely delayed implementation of internal-controls requirements for companies with market caps of less than $75 million and companies that are based abroad.

Many costs associated with S-Ox are a direct result of concerns stemming from the language of its internal-controls certification requirement. S-Ox requires accountants to certify there are no material weaknesses in a company’s system of internal controls. Three is a considerable difference of opinion as to the exact meaning of this phrase.

To the Public Company Accounting Oversight Board and others, a material weakness is determined by factoring the probability of an error by its potential magnitude. As long as this prospective product is immaterial to a company’s net worth, theres no problem.

Problems arise with events that are likely to occur, if at all, only less frequently. In a litigation following the discovery of an error and using 100% hindsight, the plaintiff’s attorney isn’t going to draw any distinction between probability and fact. As a result, a one-in-one-thousand event and incidents of higher probability are treated the same. Management must deal with both with the same degree of response. This creates considerable uncertainty for accountants during an audit and leads them to stress caution at the expense of cost.

Significant reduction of S-Ox costs requires that the term “material weakness” be abandoned. Instead, the SEC should adopt a probability-based definition: “We judge that the result of any loss would not be greater than the net equity of the entity that we are auditing.” This presentation would better represent both the assumptions that are being made as well as the uncertainties underlying the assumptions. If something is different in the future, courts would be able to debate the appropriateness of the assumptions to that particular situation, as opposed to the adequacy of the material weakness statement.

The adoption and implementation of S-Ox has had a profound impact upon corporate America. Corporations have better and faster information to make decisions, thanks to S-Ox. The cost of this information has been more than it should have been due to distinctions between accounting and legal interpretations. If legislators and regulators remove these distinctions, corporations could enjoy the benefits of S-Ox without the excessive cost or concomitant legal concerns.

Whatever happens over the coming weeks in the trial of Lay and Skilling, they have left a legacy that will endure permanently. S-Ox is here to stay, as are the myriad rules the SEC has adopted to implement it. Moreover, companies that make sensible efforts to comply will be better run, and will provide better investments for investors. Equally important, there is evidence that public confidence is slowly being restored.

Harvey L. Pitt is the chief executive officer of Kalorama Partners and was the 26th chairman of the U.S. Securities and Exchange Commission.